The Macroeconomic Effects of Fiscal Policy Shock in Ethiopia: Evidence from a Bayesian VAR Approach

Ethiopian Economics Association (EEA)
Kumadebis Tamiru Gemechu


This paper investigated the macroeconomic effects of fiscal policy shocks in Ethiopia
using a Bayesian Vector Auto Regression model. We examined the dynamic responses
of output, inflation, interest rate and exchange rate to fiscal policy shocks employing
quarterly data from 2000/01Q1 to 2015/16Q4. The empirical evidence suggests that
government spending shock had a positive impact on output and inflation but the
effect was too small. Initially the interest rate responded negatively to government
spending shocks and was positive with small effect and the nominal exchange rate
showed deterioration. In addition, government revenue shocks had positive effect on
real GDP and exchange rate and then they responded negatively. The inflation
response to the net tax was medium and negative whereas its effect on interest rate
was positive, and persistent. Furthermore, positive shocks to recurrent expenditure
had a persistent positive impact on real output. Recurrent expenditure appeared not
to be responsible for inflationary pressure. Interest rate picked up slightly as a result
of recurrent spending shocks in the short run. The response of exchange rate to
recurrent expenditure was small and remained negative. In contrast, capital
expenditure was found to have an insignificant effect on output. The reasons could be
the administrative lag and contractual bottleneck that are sometimes involved in
executing capital projects and that appeared to be responsible for inflationary
pressure. In the short term, the interest rate responded negatively and the estimated
impact on exchange rate was insignificant. Following indirect tax revenue shocks the
rise in output and inflation was very persistent. Regarding the effects of indirect taxes
on interest rate and exchange rate our results show a clear and negative impactwhereas
direct taxes were found to affect output and inflation very little and were
insignificant. Initially, interest and exchange rates responded positively to direct tax
shock later interest rate and exchange rate become insignificant and negative
respectively. The results support the idea of a ‘crowding-in’ effect and when we take
into account the feedback from government debt, the results suggest that the effects of
fiscal shocks on the majority of macro variables is too small except for the real GDP
for government revenue shock. Therefore, empirical evidence shows that it is
important to consider government debt dynamics in the model.